As mortgage rates rise to their highest level in decades, potential home buyers face higher financing costs; some potential buyers are being priced out of the market. In many cases, the interest rate on the seller’s existing mortgage is approximately half of the interest rate that the buyer might obtain on a new mortgage.
If only the buyer could keep the seller’s low mortgage interest rate! The primary obstacle is the so-called “due on sale clause” found in nearly every residential mortgage. The due on sale clause typically provides that if the seller transfers (sells) the property, the balance owed under the seller’s mortgage is due in full, unless the mortgage holder specifically consents to the transfer in writing and waives the “due on sale” provision.
This article addresses three alternatives for keeping the seller’s low mortgage interest rate that may be appropriate for certain home buyers in Minnesota.
- Assumption of Mortgage
An assumption of mortgage involves a buyer assuming the responsibility to pay an existing mortgage. Typically, the purchase price is offset by the amount that is owed on the mortgage at the closing. The buyer steps into the shoes of the seller and agrees to pay the existing mortgage according to its terms, subject to any changes that are negotiated with the mortgage holder.
The seller’s mortgage holder may require approval of the sale or of the creditworthiness of the buyer, based on a credit check, verification of income and employment, and other financial information.
In some cases, the seller’s mortgage holder may condition approval of the assumption on the interest rate being changed.
Loans insured or guaranteed by the Department of Veterans Affairs (VA) or the Federal Housing Administration (FHA) may be assumable, subject to certain requirements and conditions.
Conventional mortgages may also be assumable at the discretion of the lender. Community banks, local credit unions, and other lenders that hold mortgages in their own portfolio may be more flexible than national lenders, especially if the seller and/or buyer has a long-term relationship with the lender for personal and/or business banking.
Two scenarios in which an assumption of mortgage may be acceptable to a mortgage holder are (i) the sale of a home from a parent to an adult son or daughter, or (ii) inheritance of a home upon the death of a parent.
Caution: In some transactions, sellers and buyers do not inform the seller’s lender of transfer of ownership or obtain the lender’s consent; the buyer simply makes the monthly mortgage payments. This is not considered an “assumption of mortgage” in the typical sense of that term. The mortgage remains a lien on the real estate, and the mortgage holder may foreclose the mortgage if the mortgage payments are not made, or if there is a “due on sale” clause and the mortgage holder discovers the transfer of ownership. In addition, since the seller signed the promissory note (promise to pay), the seller remains personally liable for the loan. The lender may sue the seller based on the promissory note if buyer does not pay the debt. Finally, if the buyer defaults on the loan, that default is reported to the major credit bureaus as a default by the seller, since the lender is not aware of the transfer of the property’s ownership.
Generally, transferring ownership of real estate without paying off the existing mortgage or obtaining mortgage holder consent is a risky proposition, and is not recommended.
- Contract for Deed
In Minnesota, a contract for deed provides that the buyer will pay the seller for the property over a period of time, and after the purchase price is paid in full, the seller will give a deed to the buyer. A contract for deed triggers the “due on sale” clause under the existing mortgage unless the mortgage holder consents to the contract for deed.
Typically, the buyer makes monthly payments to the seller under the contract for deed, and the seller continues to make payments to the seller’s mortgage holder under the mortgage. The interest rate under the seller’s mortgage can be taken into consideration when negotiating the interest rate under the contract for deed. Typically, the interest rate under the contract for deed will equal or exceed the interest rate under the seller’s existing mortgage.
It is important for the buyer to review the contract for deed and to understand the rights of the seller, buyer, and mortgage holder in the event of a fire, flood, or other casualty to the property. Contracts for deed also include important provisions regarding insurance, improvements to the property, real estate taxes and assessments, remedies for default, and other terms and conditions. Most notably, a contract for deed may be canceled within just sixty (60) days of default, while the foreclosure of a mortgage takes considerably longer (a year or more).
In some transactions, sellers and buyers do not inform the seller’s mortgage holder of the sale of the property on contract for deed. In such transactions, both the seller and the buyer take the risk that the mortgage holder may learn of the contract for deed and may accelerate the mortgage, requiring payment of the entire balance that is owed. To avoid losing the property to foreclosure of the mortgage, the buyer may be forced to obtain a new mortgage at the interest rate that is available at that time, or to sell the property in order to pay off the contract for deed and the seller’s mortgage. If interest rates are high or if there is a downturn in the real estate market, the seller and the buyer may be in a difficult position.
Important Notes regarding Assumption of Mortgage or Contract for Deed:
- If a buyer desires to make an offer to buy a home contingent on receiving the mortgage holder’s consent to an assumption of mortgage or contract for deed and a waiver of any applicable “due on sale” provision, then the purchase agreement should include an appropriate contingency specifically addressing the details. Keep in mind that the approval process can take quite some time, so buyers and sellers should plan accordingly when setting the closing date.
- VA and FHA mortgages may be assumable, subject to certain requirements. It is important that the parties check with the lender regarding the requirements that apply to the specific transaction as early in the purchase process as possible.
- It is important for the buyer to review the documents related to the seller’s existing mortgage. The seller may have a very low mortgage interest rate, but what are the other terms and conditions? For example, is the interest rate fixed or adjustable? Is there a balloon payment?
- It is important for the seller to understand the impacts of a mortgage assumption or a contract for deed. For example, will the seller remain personally liable for payment of the mortgage? Will the seller qualify for a new VA or FHA loan to buy the next property? The answers may vary depending on the specific facts and the negotiated agreement in each transaction.
- Sellers and buyers should not simply rely on discussions or informal written communication with a lender. It is important that any agreements be made in formal, legally binding documents.
- Lease with Option to Buy
A lease with an option to buy creates a landlord-tenant relationship, and gives the tenant the right to purchase the property in the future, subject to the terms and conditions of the agreement.
The terms and conditions of the option to buy are subject to negotiation between the landlord and the tenant. For example, the option to buy may provide that if the tenant exercises the option, then the tenant will receive a credit toward the purchase price based on a certain amount or percentage of the rent that was paid each month.
A lease with an option to buy may provide time for a tenant to improve his/her credit rating and financial position, and the tenant may benefit if interest rates for a new mortgage are lower in the future.
A lease with an option to buy typically does not trigger the “due on sale” clause in the landlord’s mortgage. However, an option to buy generally is not legally binding on the landlord’s mortgage holder. The tenant takes the risk that, if the landlord fails to pay the mortgage and the lender forecloses the mortgage and ownership of the property is transferred to the lender or to a third party, the tenant will not receive the benefit of the option to buy. Similarly, if the landlord is purchasing the property on a contract for deed, and if the contract for deed is terminated based on the landlord’s default, the tenant’s option to buy generally will not be enforceable.
A lease with an option to buy generally does not automatically give the tenant the right to assume the landlord’s mortgage if the tenant exercises the option to buy the property. However, the parties may benefit from the landlord’s low mortgage interest rate during the term of the lease.
Please Note: The information in this article is provided solely as general information and not as legal advice. Receipt of this information or its use does not establish an attorney-client relationship. Readers are urged to speak with a qualified attorney when making decisions regarding a specific legal issue. For questions about any issue regarding real estate transactions, please feel free to contact the author.